A sugar rush of epic proportions drove markets to the moon immediately following a Covid outbreak. Even the rebuilding during World War II didn’t see as much cash thrown into our economy (on an adjusted basis to today’s real dollar amount):
The battle to tame inflation has likely hit its apex as market fears now shift to if a recession is coming and how strong it will be. Stocks and bonds price in what is a base case for 9-12 months from now. With interest rates collapsing, oil finally coming down, many commodity prices getting crushed, one has to wonder if we still have a lot more negative economic news coming and how bad a recession may become.
This influx of cash helped fuel a massive rally, but also a hangover only a year after seeing trillions of dollars thrown at the economy. Pulling this stimulus back will not be as quick (or fun) as when it was sent out. Judging by the past two weeks of market movement, some black clouds are showing out in the distance:
• Corn and wheat are down 20% and 25%, respectively, from recent highs.
• Copper, steel, aluminum and other metals are down 25% – 60%.
• Natural gas and oil are showing some cracks, down 35% and 20% in just 3 weeks.
• On the stock side, Freeport-McMoran, the leading copper provider, is at a new 52-week low after falling 45% in three months. “Dr. Copper” has a proven track record for future growth prospects.
• Oil service providers are down 30% in two weeks.
• Super cyclicals such as housing stocks were down ~50% before bouncing this week. Other economically sensitive mega-caps such as Caterpillar (down 5% on the Thursday) and Deere (down 6%) made new annual lows yesterday.
• Retailer inventories are up 30%+ and discounts are all over the place, being led by Walmart and Target.
• Lastly, and what drove equity action this week, interest rates have collapsed across the curve. 10-year Treasury yields almost touched 3.5% last week and hit 3.0% yesterday! Similar action is seen globally with the 10-Year German Bund collapsing from 1.9% to 1.4%.
This is a massive amount of negative activity in goods and services, the building blocks of any economic expansion. All while we are supposed to be worried about inflation. Today, it looks as if the market is anticipating a significant reduction in growth, a probable recession, and inflation coming down quickly. We could be going from inflation fears to recession fears in the blink of an eye. Although not nearly a perfect comparison, the last time inflation was well above trend was during the Financial Crisis. In July 2008, CPI peaked at a 5.6% rate. Nearly nine months later, it morphed into deflation, coming in at a negative 2.1%. We are not calling for negative inflation next year, but it can’t entirely be ruled out. With an economy as fragile as we’ve seen over the past several years (anyone recall the Fed-induced tantrum of 2018 where stocks cratered 20% from October into Christmas Eve?), the massive amount of debt thrown at the pandemic is concerning.
While it is true that there is a lot of cash sitting on the sidelines, and corporations’ debt service levels are in great shape, when you break it down company by company the picture becomes less optimistic. First, debt levels are a lot higher today than ever before. This has been fine for most, especially since interest rates were sub 1%. It is easy to service a lot of debt when interest payments are next to nothing. Now that rates have spiked, what happens when that debt matures and your 1% rate goes to 5%? Corporations have 2 options, either to pay back the loan or refinance it. The ability to repay said loan is dependent on cash flows. Here is where things get interesting and outright frightening. The top 10 companies in the S&P have more cash on hand than the next 400. The bottom 100 companies, #401 thru #500, only have $20B on hand combined! Overall, cash balances look high, but they are heavily concentrated in mega-cap technology stocks, not the middle of the road organizations. Higher interest rates could put many well-known businesses behind the proverbial 8-ball.
While cyclicals and “value” stocks were taking it on the chin this week, money flew back into growth and beaten down sectors. Higher rates helped bring P/E’s down…lower rates could do the opposite. When growth is scarce, those that can actually deliver find a home in portfolios. Accenture# reported stellar earnings this week. Oracle# and Adobe# had solid top line growth with a consistent demand theme going forward. Even the Ark Innovation Fund is showing signs of life with a double bottom and 25% run over the past month.
It is often noted that when the Y2K bubble burst, numerous stocks never regained their highs. Looking at the laundry list of no-earnings, Covid-boom stocks dropping 75%+ over the past year reminds us of that period. However, not all companies are created equal. Looking at Cisco for instance, the stock peaked in the year 2000 at $77 and has still never regained that level. However, the stock got to $8 in 2002 and was back to $30 a couple years later. Quite a decent investment if one waited for a proper valuation entry point.
There are many examples of Y2K winners that don’t exist right now, but comparisons to that period have to be taken with a grain of salt. Some turned out to be great purchases, once they finally got to a “fair value” price level. That is where the hard work comes in today. Will Zoom (up 45% in six weeks) simply survive or possibly thrive going forward? Will Peloton (still making new lows) find a new avenue for revenues outside of home gyms? If Metaverse is real, shouldn’t Roblox (up 47% in six weeks) participate? Is Snowflake (up 20% this week alone) the data analytics platform for the future? Does QuantumScape (still near lows) have a competitive advantage in battery storage that will bring market share gains over the coming EV revolution? These stocks have been crushed. Many will never get back to 2020 highs, but many don’t need to in order to offer upside opportunities. Transition periods, market cleansing washouts and significant drawdowns in stocks create prospects for astute investors. We still recommend only looking at those with real earnings and positive cash flow.
We certainly are not recommending any of these names yet, but investors need to recognize that the future investing world is going to be different than the past decade. Market cycles change, especially after a significant correction. The 1990’s were characterized by a massive technology bull market. Prior to that it was the big-cap pharma bull market as many amazing medicines came to market. Before that was a commodities boom, led by energy. Another commodities boom also came after the dotcom bust as well. The next boom is coming once the Fed is done fighting this inflationary spiral and the leaders are likely to be different than the last bull market.
A couple weeks of reversals of recent trends does not mean that the above is certain, but worth monitoring as the Fed goes nuclear with multiple 75bps rate hikes getting priced in, along with a quantitative tightening plan just getting warmed up. Many commodities, especially oil, are still up substantially this year. Oil stocks are still up 20% – 40%. We have already seen multiple oversold rallies for tech stocks. There is much more data coming down the road and those dark clouds could dissipate. Be wary of making any large bets this early into the next transition, but the point remains that growth is the next real concern. How far does the Fed have to go in order to stop inflation?
Soccer star Lionel Messi turns 35 today. Many may not know her name, but Solange Knowles has her own #1 album and is the less famous sister of Beyonce. She turns 36 today. Mindy Kaling is now 43.
James Vogt, 610-260-2214